1. Field of the Invention
The present invention relates generally to financial products and, more particularly, to financial instruments related to mortgage lending and the securitization and servicing of mortgage loans.
2. Related Art
Consumers who desire to purchase a home must often borrow funds from a lender (e.g., a bank, mortgage finance company or the like). As is well known in the relevant art(s), the legal document where the consumer (i.e., the borrower) uses the property as security to guarantee repayment of the loan is known as a mortgage.
Today, lenders sell over half of all mortgage loans they originate into the secondary market. By selling mortgage loans on the secondary market, lenders liberate capital in order to have funds to meet additional consumer demand for home mortgages. That is, the secondary market keeps the supply of money for housing widely available and ultimately lowers costs to consumers.
Within the secondary market, lenders normally sell the mortgage loans to a secondary market conduit or wholesaler. Lenders may sell a single mortgage loan at a time or sell several mortgage loans at a time to a wholesaler. The wholesaler then packages the purchased mortgage loans into pools. For example, a typical pool may consist of ten loans with a total principal amount of $1 million or 3,000 mortgage loans with a total principal amount of $300 million. A wholesaler typically enhances the mortgage loan pools by guaranteeing full payment of the mortgage loans and providing administrative services for the pool. The wholesaler then forms the enhanced mortgage loan pools into securities and sells them to investors. This process is known as securitization. Investors that purchase the securitized mortgage loan pools are typically banks, pension funds, insurance companies, money market funds or other institutions. The wholesaler that purchases and securitizes the mortgage loan pools takes on a variety of risks. When the wholesaler guarantees the mortgage loan, it accepts the risk that the borrower may default on the mortgage loan. If default occurs, the wholesaler must pay the mortgage principal due on the mortgage loan to the investor.
The wholesaler also accepts the risks associated with the administration of the securitized mortgage loan pool. Administrative duties on the securitized mortgage loan pool include remitting borrower mortgage payments to investors on a monthly basis, making payments to investors on its guarantees, tax reporting and transfer and registrar functions on the securities. To perform its administrative duties on the securitized mortgage loan pool adequately, the wholesaler must assure that the mortgage loans are properly serviced.
Servicing of mortgage loans generally involves all functions relating to the borrower's responsibilities on the mortgage. These functions include, for example, sending to the borrower a coupon book that indicates when monthly payments are due and the amount of the payment, calculating and collecting escrow balances, and paying taxes and insurance from the escrow balances. The servicing function requires significant time and attention. For example, if the borrower is late on a payment, the servicer must contact the borrower to discuss the missed or late payment, write a letter to a delinquent borrower after payments are sixty days late, and so on. Servicing also includes all actions necessary to foreclose upon defaulted mortgage loans. Servicing responsibilities end when the mortgage loan is fully paid at the end of its fixed term (e.g., a 30 year fixed loan), the mortgage loan is fully paid in advance (i.e., prepayment) or when the mortgage loan is foreclosed upon for a payment default.
Lenders sometimes perform the servicing functions on the mortgage loans they originate. However, lenders may not wish to undertake servicing responsibilities for a variety of business-related reasons. Lenders that do not wish to perform the servicing functions for a mortgage loan typically sell the right to perform the servicing function to another company, which may be another lender (i.e., a lender/servicer) or a company that specializes in servicing mortgage loans (i.e., a servicer). When a wholesaler purchases mortgages from lenders, the wholesaler becomes responsible for servicing the mortgage loan. Wholesalers normally do not themselves perform the mortgage loan servicing function. Therefore, a wholesaler normally permits the existing relationship between the borrower and the servicer to continue and it pays the servicer to service the mortgage loan.
The contractual right to service a mortgage loan is known as a mortgage servicing right (MSR) contract. Traditionally, the MSR contract has permitted the servicer to retain not only a portion of the interest paid on the mortgage loan by the borrower but also ancillary revenue from float income on escrow balances, float income on principal and interest payments held prior to remittance to the wholesaler, ancillary fees such as late payment fees and any collateral benefits resulting for the servicer's relationship with the borrower (known as “cross-sell opportunities”). The interest portion that wholesalers permit servicers to retain are established by each wholesaler. They are typically expressed as a minimum for a mortgage type, such as a minimum of 0.375% interest for an adjustable-rate mortgage, or a minimum of 0.25% interest for a fixed-rate mortgage. For example, if a wholesaler purchases a fixed-rate mortgage loan with an 8% interest rate, the wholesaler might retain 7.75% interest on the principal balance of the mortgage loan and might permit the servicer to retain 0.25% interest on the principal balance of the mortgage loan. This is known as an “interest strip.
When a servicer acquires an MSR contract, it books as an asset on its books the net present value of the expected income from the MSR contract. The valuation includes the income the servicer expects to receive from all the normal attributes of a mortgage servicing right contract, including the interest percentage, float and fee income and the benefits of the cross-sell opportunities. The servicer places the value of the MSR contract asset on its books in the year the MSR right is acquired. Thereafter, the servicer amortizes the asset over the remaining term of the mortgage loan.
Like wholesalers, servicers also face risks. The primary risk is that the servicer's income will be reduced if the borrower prepays the mortgage loan earlier than expected. If a mortgage loan is prepaid, no further interest is due from the borrower, and the interest cash flow and ancillary income from the serviced mortgage loan ceases.
Because servicers face risks on MSR contracts, they typically engage in “hedging.” As is well known in the relevant art(s), hedging is the process of protecting a position. It is the placement of a position to offset an exposed cash or physical market position. Hedging is often done through the trading of financial instruments known as derivatives. A derivative is an investment vehicle whose value is based on the value of another security or underlying asset. That is, a derivative is essentially a financial instrument that is derived from the future movement of something that cannot be predicted with certainty. Common examples of derivatives include futures contracts, forward contracts, options and swaps. Derivatives help in managing risks by allowing banks, companies, organizations and the like to divide their risk into several pieces that may be passed off to other entities who are willing to shoulder the risk for an up-front fee or future payment stream.
The use of derivatives to counter MSR contract risk, however, exposes servicers to other risks because the relationship between the value of a derivative and the underlying asset are not linear and can be very complex. Economists have developed several pricing models in order to value certain types of derivatives. Each model, however, has inherent limitations and thus poses additional risks. In essence, while attempting to limit their MSR contract exposure by hedging, servicers are exposed to the risk of pricing derivatives. The complexity of managing this risk is evident from the availability of sophisticated software packages to price, hedge and account for MSR contracts such as the WinOAS™ software package available from Mortgage Industry Advisor Corporation of New York, N.Y.
Further complicating the use of derivatives for hedging of MSR contracts is the Financial Accounting Standards Board (FASB) Statement (FAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” which takes effect on Jan. 1, 2001. As is well known in the relevant art(s), FASB is the designated organization in the private sector for establishing standards of financial accounting and reporting. Those standards govern the preparation of financial reports. They are officially recognized as authoritative by the Securities and Exchange Commission. FAS 133 will make the accounting treatment of hedging more complex and volatile.
Additionally, the average size of home mortgages has increased dramatically in recent years. Since MSR contracts are traditionally based on the principal amount of the mortgage loans, servicer compensation has increased while the servicer's cost of servicing has been stable or even decreased. Thus, there is no longer a direct and justifiable connection between current servicing compensation and servicing costs.
In reaction to the above situations, the marketplace has identified several possible approaches.
First, it has been proposed to reduce the servicer's interest strip below the current minimum, down to 0.10%. This would somewhat reduce the need for and cost of hedging. However, this approach is not entirely satisfactory. It significantly lowers the income to the servicer on the MSR. Thus, this approach concerns many investors in securitized mortgage pools who worry about experiencing lower yields because the underlying mortgage loans will not be attentively serviced for such a low fee.
Second, it has been proposed to replace the interest strip provisions in MSR contracts with a “fee for service” type arrangement. For example, a servicer would be paid “$50 per mortgage loan per year” for servicing. This proposal removes the volatility to the servicer's income statement and balance sheet resulting from MSR hedging activity. However, this approach is not entirely satisfactory because it does not receive the tax and accounting treatment preferred by servicers. Investors in securitized mortgage pools have the same concerns about this approach as they do for the first approach described above.
Third, it has been proposed that servicers be paid a flat fee up front for servicing each mortgage loan throughout its term. However, this approach is not entirely satisfactory because servicers could not be certain that the single payment would adequately compensate them for the costs and risks of servicing.
Therefore, what is needed is a method that provides the income and accounting attributes of the current MSR contracts as well as an efficient method of managing hedging risk.